Many investment options such as bank term deposits, SCSS, the Post’s Monthly Income Plan, and PMVVY, among others, have one thing in common. The resulting interest income is taxable in the hands of the investor in the year of receipt. Do you want to invest in a fixed income instrument and not pay tax on interest income? Yes, it is possible if you buy bonds tax free.
Simply put, a tax-free bond is almost similar to a fixed deposit when it comes to investing. A lump sum can be invested in a tax-free bond that carries a fixed interest rate for a specified term. At maturity, the capital is returned to the investor. There is no issuance of tax-free bonds coming into the market, but you can invest in those bonds which are publicly traded.
Most of the tax-free bonds, which were issued earlier and are now listed on the NSE, BSE stock exchanges, come from government-backed institutions such as Indian Railway Finance Corporation Ltd (IRFC), Power Finance Corporation Ltd (PFC) , National Highways Authority of India (NHAI), Housing and Urban Development Corporation Ltd (HUDCO), Rural Electrification Corporation Ltd (REC), NTPC Ltd and Indian Renewable Energy Development Agency. Most of them have the highest security ratings when it comes to receiving interest and principal at maturity.
Characteristics of non-taxable bonds
Non-taxable bonds have a longer term of 10, 15, 20 years. Yet, on the exchanges, many of them are also available with a lesser maturity period. And, even though they are publicly traded, the liquidity of tax-free bonds is low. Therefore, only invest in them if you are sure that you will not need the funds for such a long time. The interest on these bonds is tax free and there is also no withholding tax (TDS). Additionally, they typically offer annual, not monthly, interest payments, which may not meet a retiree’s regular income requirements. If it is held to maturity, security of principal and interest exists.
The face value of a non-taxable bond is generally Rs 1000. On the stock market, depending on the due date of interest payments or the evolution of interest rates in the economy, it can be traded with a discount or a premium compared to its face value. For example, a bond of Rs 1000 may be available in the market at Rs 980 or Rs 1078.
The coupon rate is the fixed interest rate on the bond. It determines the amount of interest income that will be received by the investor. For example, even if an investor bought a bond of Rs 1000 carrying an interest rate of 8.2% per annum, at the market price of Rs 1078, the interest payment of Rs 80.20 is received by the investor. But, the investor had bought the bond worth Rs 1000 at a higher price of Rs 1078. Therefore, the return or the actual return will be lower.
When the purchase price is high, the yield will generally be low relative to the coupon rate. Interest income received on the basis of the coupon rate will however be tax free in the hands of the investor. The due date is also an important factor to consider when investing in them. If you wish to sell it before maturity, the gains, if any, will be subject to capital gains tax.
Who they suit
Non-taxable bonds are suitable for investors in the highest tax bracket who pay 30% tax on taxable investments such as bank term deposits. For someone who pays tax at the highest rate and invests in a 6.5% taxable deposit such as FD bank, the after-tax rate is around 4.47%.
Non-taxable bonds are exempt from the obligation to pay income tax on interest income received. Investors investing in non-taxable bonds are not required to pay tax on semi-annual or annual interest payments and there is no tax liability on the principal amount received at maturity.